chapter 11 capital budgeting and risk analysis
Download
Skip this Video
Download Presentation
Chapter 11: Capital Budgeting and Risk Analysis

Loading in 2 Seconds...

play fullscreen
1 / 24

Chapter 11: Capital Budgeting and Risk Analysis - PowerPoint PPT Presentation


  • 95 Views
  • Uploaded on

Chapter 11: Capital Budgeting and Risk Analysis.  2002, Prentice Hall, Inc. Project Standing Alone Risk. Three Measures of a Project’s Risk. Project Standing Alone Risk. Risk diversified away within firm as this project is combined with firm’s other projects and assets.

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Chapter 11: Capital Budgeting and Risk Analysis' - reese


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
three measures of a project s risk1
Project Standing

Alone Risk

Risk

diversified away

within firm as this

project is combined

with firm’s other

projects and assets

Three Measures of a Project’s Risk
three measures of a project s risk2
Project Standing

Alone Risk

Risk

diversified away

within firm as this

project is combined

with firm’s other

projects and assets

Project’s

contribution-

to-firm risk

Three Measures of a Project’s Risk
three measures of a project s risk3
Project Standing

Alone Risk

Risk

diversified away

within firm as this

project is combined

with firm’s other

projects and assets

Project’s

contribution-

to-firm risk

Risk

diversified away

by shareholders as

securities are combined

to form diversified

portfolio

Three Measures of a Project’s Risk
three measures of a project s risk4
Project Standing

Alone Risk

Risk

diversified away

within firm as this

project is combined

with firm’s other

projects and assets

Project’s

contribution-

to-firm risk

Risk

diversified away

by shareholders as

securities are combined

to form diversified

portfolio

Systematic risk

Three Measures of a Project’s Risk
incorporating risk into capital budgeting
Incorporating Risk into Capital Budgeting

Two Methods:

  • Certainty Equivalent Approach
  • Risk-Adjusted Discount Rate
how can we adjust this model to take risk into account1
n

t=1

S

ACFt

(1 + k)

NPV = - IO

t

How can we adjust this model to take risk into account?
  • Adjust the After-tax Cash Flows (ACFs), or
  • Adjust the discount rate (k).
certainty equivalent approach
Certainty Equivalent Approach
  • Adjusts the risky after-tax cash flows to certain cash flows.
  • The idea:
certainty equivalent approach1
Certainty Equivalent Approach
  • Adjusts the risky after-tax cash flows to certain cash flows.
  • The idea:

Risky Certainty Certain

Cash XEquivalent = Cash

Flow Factor (a) Flow

certainty equivalent approach2
Certainty Equivalent Approach

Risky Certainty Certain

Cash X Equivalent = Cash

Flow Factor (a) Flow

Risky “safe”

$1000 .70 $700

certainty equivalent approach3
Certainty Equivalent Approach

Risky Certainty Certain

Cash X Equivalent = Cash

Flow Factor (a) Flow

Risky “safe”

$1000 .95 $950

certainty equivalent method
n

t=1

t ACFt

(1 + krf)

NPV = - IO

Certainty Equivalent Method

S

t

certainty equivalent approach4
Certainty Equivalent Approach
  • Steps:

1) Adjust all after-tax cash flows by certainty equivalent factors to get certain cash flows.

2) Discount the certain cash flows by the risk-free rate of interest.

how can we adjust this model to take risk into account3
n

t=1

S

ACFt

(1 + k)

NPV = - IO

t

How can we adjust this model to take risk into account?
  • Adjust the discount rate (k).
risk adjusted discount rate
Risk-Adjusted Discount Rate
  • Simply adjust the discount rate (k) to reflect higher risk.
  • Riskier projects will use higher risk-adjusted discount rates.
  • Calculate NPV using the new risk-adjusted discount rate.
risk adjusted discount rate1
n

t=1

S

ACFt

(1 + k*)

NPV = - IO

t

Risk-Adjusted Discount Rate
risk adjusted discount rates
Risk-Adjusted Discount Rates
  • How do we determine the appropriate risk-adjusted discount rate (k*) to use?
  • Many firms set up risk classes to categorize different types of projects.
risk classes
Risk Classes

Risk RADR

Class (k*) Project Type

1 12% Replace equipment,

Expand current business

2 14% Related new products

3 16% Unrelated new products

4 24% Research & Development

summary risk and capital budgeting
Summary: Risk and Capital Budgeting

You can adjust your capital budgeting methods for projects having different levels of risk by:

  • Adjusting the discount rate used (risk-adjusted discount rate method),
  • Measuring the project’s systematic risk,
  • Computer simulation methods,
  • Scenario analysis,
  • Sensitivity analysis.
ad